Thoughts on the Market: The Outlook for European Stocks in 2026

Date: December 9, 2025
Host: Paul Walsh (PW), Morgan Stanley's Head of Research Product in Europe
Guest: Marina Zavlak (MZ), Chief European Equity Strategist

Episode Overview

This episode dives into Morgan Stanley’s forecasts and key themes shaping the European stock market for 2026. Paul Walsh and Marina Zavlak review 2025's performance, dissect the critical forces expected to drive (or drag on) European equities, and detail their sector preferences going forward. The conversation is candid, data-driven, and rich with insights for investors seeking to navigate the complexities of the coming year.

Key Discussion Points & Insights

2025 in Review: A Year of Two Halves

• First Half: Europe outperformed expectations largely due to:

  • Germany’s unprecedented fiscal stimulus
  • Optimism around Russia-Ukraine peace talks
  • Tariff worries leading investors to diversify from US equities to Europe
  • “That was a first half kind of dynamic.” (MZ, 01:32)

• Second Half:

  • Growth lagged as European optimism peaked in March
  • Execution on German fiscal promises was slower than anticipated
  • “Europe just generally has had weak earnings growth. So we started the year at 8% consensus earnings growth for 2025. At this point, we're at minus 1 for this year.” (MZ, 02:14)

Outlook for 2026: Three Key Buckets

1. The ‘Slipstream’ Effect from the U.S.

• Europe’s direction remains closely tied to U.S. market strength:
  • U.S. equity strategists at Morgan Stanley are bullish, forecasting 15% S&P upside
  • For Europe, upside is expected to come more from multiple expansion rather than earnings growth
  • “It's very, very hard for European equities to go down if the US market is up 15%. But our upside is more driven by multiple expansion than it is by earnings growth.” (MZ, 03:17)
  • European markets trade at about a 26% discount to U.S. equivalents, sector-adjusted

2. Thematic Drivers and Sector Headwinds

• Earnings expectations are high:
  • Consensus anticipates ~13% growth; Morgan Stanley forecasts just under 4%
  • “Consensus is almost anticipating almost 13% earnings growth. We're anticipating just below 4% earnings growth. So we do expect downgrades.” (MZ, 03:38)
• China’s Competition & Europe’s ‘Old Economy’:
  • Ongoing competition from China explains ~60-90% of recent European earnings downgrades
  • Sectors most at risk: chemicals, autos, and (arguably) luxury goods
• Germany’s Fiscal Story:
  • Excitement over a €500bn infrastructure fund is dampened by slow execution and a pivot toward social spending
  • More optimism is found in defense spending, which is starting to see real follow-through
• AI as a Wild Card:
  • Europe is well-positioned for widespread AI productivity gains due to “a lot of low hanging fruit in terms of productivity, challenges, demographics, you know the level of returns.” (MZ, 06:37)
  • Real transformation seen as likely from H2 2026 onward—if ROI on AI adoption proves meaningful

3. Sector Preferences for 2026

• New quantamental model integrates themes, cycle views, and data-driven signals
• Top sector:
  • Banks—offer earnings resilience, strong positive earnings revisions, cheap valuations (approx. 9x P/E), and high shareholder returns
    • “Banks is the sector that consistently delivers the highest positive earnings upgrades of any sector in Europe and is still not expensive at all.” (MZ, 08:35)
• Other Overweights:
  • Defense—upgrades reflecting increased demand and momentum
  • Utilities—breaking out of multi-year downtrends, huge capex on energy transition, benefiting from surging power demand (notably due to AI)
    • “There’s just this endless demand for power on the back of powering AI, investors are more willing to benefit the sector for those returns.” (MZ, 09:50)

Notable Quotes & Memorable Moments

• On the year’s split performance (2025):
  • “I would say, is a year of two halves...” (MZ, 00:50)
• On European optimism peaking:
  • “…in March, that European optimism had peaked. And the second half was more focused on the execution on Germany’s fiscal [policy] ... which has been a little bit slower than investors were anticipating.” (MZ, 01:55)
• On U.S. market influence:
  • “It’s very, very hard for European equities to go down if the US market is up 15%.” (MZ, 03:12)
• On China’s ongoing impact:
  • “…China competition piece drive between 60 and 90% of European earnings downgrades.” (MZ, 05:03)
• On Banks:
  • “…banks is the sector that consistently delivers the highest positive earnings upgrades of any sector in Europe and is still not expensive at all.” (MZ, 08:38)
• On Utilities and AI-driven demand:
  • “…this endless demand for power on the back of powering AI, investors are more willing to benefit the sector for those returns.” (MZ, 09:50)
• On AI adoption as Europe’s potential leap:
  • “If AI adoption ROI starts to become material enough that it's hard to ignore ... then Europe could be seen as much more of a play on AI adoption.” (MZ, 06:39)

Timestamps for Key Segments

• 00:50 – 02:23: 2025 in Review
• 02:23 – 04:04: The U.S. ‘Slipstream’ Effect
• 04:19 – 07:35: Thematic Drivers, Structural Challenges, and the AI Wild Card
• 07:47 – 10:23: Sector Preferences and Model Insights

Summary Table: Sector Positioning for 2026

| Sector | Outlook | Rationale/Drivers | |----------------|---------------|---------------------------------------------------------------------| | Banks | Overweight | Earnings resilience, positive revisions, cheap, high returns | | Defense | Overweight | Execution picking up, increasing demand, but small index weight | | Utilities | Overweight | AI-driven demand, capex cycle, valuation vs. US peers | | Chemicals, Autos, Luxury | Underweight | High China exposure, ongoing demand softness, weak growth |

Final Thoughts

Paul Walsh and Marina Zavlak deliver a nuanced, data-backed forecast for European equities in 2026. While challenges remain—especially from China and slow policy execution—sectors like banks, defense, and utilities are best positioned to capture upside. The broadening U.S. recovery and Europe’s unique leverage to late-cycle and AI adoption could offer notable opportunities, especially for investors willing to look past old economy headwinds.